Private credit and private equity are both so-called alternative investments because they don’t trade in public markets like traditional stocks and bonds do. They are both private investments, which means they are similar in some respects, but they are also different in critical ways. The most significant difference is that private equity investors receive a share of ownership of the companies they invest in, while private credit investors do not.
What is private credit?
Private credit, also known as private debt, is a type of investment where the investors lend money to businesses and earn a return by charging interest on the loan. These loans are usually made to companies (although some are made to individuals) that don’t qualify for traditional bank loans. The bulk of private credit loans are made to mid-sized companies, although some of these lenders also extend credit to smaller businesses, distressed businesses, and real estate investors.
Unlike publicly traded bonds—another kind of loan—the public typically can’t invest in these assets, which is why they are referred to as private credit.
Private credit can carry more risk than traditional loans because borrowers are often below investment grade, meaning there is a higher chance they will have trouble repaying the debt. Traditionally, non-investment grade borrowers are graded as BBB or lower by credit ratings firms like Standard & Poor's or Moody's. Because of this low rating, investors usually demand a higher interest rate to offset the risk of default.
Loans made by private credit firms may last for a number of years, meaning investors generally won’t have access to their capital for the duration of the loan.
What is private equity?
Private equity is an investment in the ownership of a private or public company that may be delisted from a stock exchange. These investments are similar to stock ownership except that private equity stakes are not publicly traded.
Private equity investments are usually made by firms that specialize in this kind of investing. To qualify to invest in private equity, an organization or person might be required to invest millions of dollars, or be what’s known as an accredited investor. This makes private equity relatively inaccessible to the average retail investor. Most investors in private equity are large institutions such as pension funds and endowments. Large private equity firms such as Blackstone and the Carlyle Group will also have branches that focus on private credit.
Much like private credit, private equity investments often require an investor to be locked in for years or even decades, making the investment illiquid. In return for this illiquidity, investors often expect higher returns than they would earn from investing in the public stock or bond markets.
The term private equity also sometimes includes venture capital, which is investment in start-up companies that have yet to sell shares to the public.
Private credit vs. private equity: Key similarities and differences
Similarities between private credit and private equity
Private credit and private equity investments share a number of key characteristics including:
- Private. As implied by their names, both of these investment types are not open to the general investing public.
- High entry requirements. Many large private equity and private credit funds require investors to pass a number of stringent financial qualifications. They often require millions of dollars as a minimum investment. Individuals must meet accreditation standards based on personal wealth and financial sophistication to make these investments.
- Management fees. Private markets firms usually charge investors fees in exchange for managing investments in private equity and private credit.
- Illiquid. Both of these asset classes can lock the investor in for several years at a time, making it very difficult for an investor to access their money.
- Higher returns. As a consequence of the illiquid nature of these assets, both investment types can offer higher returns than investments in public markets. These higher returns are known as a liquidity premium.
- Low correlation. Both private credit and private equity don’t necessarily move in step with the short-term ups and downs of public markets. This is known as low correlation and owes, in part, to the long-term nature of the investment.
- Rapid growth. Both of these asset classes have expanded rapidly. According to an SEC report, the pace of growth in private investments has far outpaced growth of public equities during the past two decades.
- Dominated by institutional investors. Both of these asset classes tend to cater to large institutional investors such as pension funds, endowments, and foundations.
Differences between private credit and private equity
Nevertheless, private credit and private equity have some major differences such as:
- Ownership. Private equity investments result in partial or complete ownership of a company. Private credit investments are loans to a company or sometimes an individual, but there is no ownership involved.
- Predictability. Private credit returns a predetermined interest rate through a repayment plan agreed upon by both the borrower and the lender (unless the debtor defaults). Private equity returns depend entirely on the success of the company in which the fund invested. Private equity investors don’t recoup any money unless the company is sold or goes public. If a company performs well, the returns could be very large, while if a company underperforms, the returns could be small or even result in significant losses.
- Potential returns. Private equity investments, in theory, have no upper limit on how much they will return, while private credit can only return the loan principal and interest rate agreed upon by borrower and seller.
- Risk. If a company goes bankrupt, the company is usually obligated to pay creditors such as lenders (private credit investors) before it pays its equity holders (private equity investors). Equity holders will only be paid if there are any assets left after all creditors have been paid off, meaning they risk being wiped out.
- Size of market. Private equity is a larger industry than private credit. Private equity had approximately $9.8 trillion in assets under management in June 2021, according to McKinsey. Private credit, on the other hand, had roughly $1.1 trillion in assets under management that year, according to PwC.
The bottom line
Both private equity and private credit are investments that are not widely available to the public. Both usually are long-term investments and can tie up investors’ money for many years. A key difference, however, is that private equity involves a direct investment in the ownership of a company while private credit simply lends money without taking an ownership position.
Private equity is a much larger industry than private credit, but both have grown significantly during the past two decades. They have become especially important to institutional investors like pension funds and endowments, many of which are increasing how much of their assets they devote to private markets.